Investment Management

On August 23rd, the Second Circuit issued its much-anticipated opinion in U.S. v. Martoma, affirming the 2014 insider trading conviction of S.A.C. Capital Advisors portfolio manager Matthew Martoma.[1] In doing so, it clarified an important point regarding what is required to convict a person who trades on a tip received from an insider. We believe this decision will have an immediate impact on how hedge fund portfolio managers and other investment advisers interact with third party resources.

Section 10(b) of the Securities Exchange Act of 1934[2] and Rule 10b-5[3] promulgated thereunder prohibit insider trading. The basic elements of insider trading are: (i) engaging in a securities transaction, (ii) while in possession of material, non-public information, (iii) in violation of a duty to refrain from doing so.

Under the classic theory of insider trading, a corporate insider trades in shares of his employer while in possession of material, non-public information (e.g., advance notice of a merger). In addition to the classic theory of insider trading, case law has extended the liability to persons who receive tips from insiders (i.e., individuals whose duty to refrain from trading is derived or inherited from the corporate insider’s duty). Thus, not only may insiders be liable for insider trading, but those to whom they pass tips, either directly (tippees) or through others (remote tippees) may be liable if they trade on such tips.

The seminal case involving tippee liability is Dirks v. SEC.[4] In Dirks, the U.S. Supreme Court held the following:

In determining whether a tippee is under an obligation to disclose or abstain, it is necessary to determine whether the insider’s “tip” constituted a breach of the insider’s fiduciary duty. Whether disclosure is a breach of duty depends in large part on the personal benefit the insider receives as a result of the disclosure. Absent an improper purpose, there is no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach.[5]

The question of what constituted a “personal benefit” was left ill-defined until the Second Circuit gave it shape in U.S. v. Newman.[6]Newman held that a tipper and tippee must have a “meaningfully close personal relationship” and that the insider information be divulged in exchange for “a potential gain of a pecuniary or similarly valuable nature” for the court to find the tipper had breached his fiduciary duty to the source.[7] For a period of time after the Second Circuit issued its opinion in Newman, it seemed that Martoma’s conviction was likely to be overturned.

Unfortunately for Martoma, the U.S. Supreme Court issued its opinion in U.S. v. Salman while Martoma’s appeal was pending.[8] In Salman, the U.S. Supreme Court flatly rejected certain aspects of the Newman holding and called others into question.[9] Accordingly, the Second Circuit held in Martoma that “Salman fundamentally altered the analysis underlying Newman’s ‘meaningfully close relationship’ requirement such that the ‘meaningfully close personal relationship’ requirement is no longer good law.”[10]

In Martoma, the court held that rather than looking at objective elements of the relationship between tipper and tippee, the proper inquiry is now whether the corporate insider divulged the relevant information with the expectation that the tippee would trade on it.[11] This is “because such a disclosure is the functional equivalent of trading on the information himself and giving the cash gift to the recipient.”[12]

Please contact us if you have any questions about the Second Circuit’s opinion in Martoma or the law concerning insider trading generally.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s Winston-Salem and New York offices. John I. Sanders is an associate based in the firm’s Winston-Salem office.

Perhaps the most serious charge that could be leveled against a reader of this blog is that of being engaged in or associated with “insider trading.” The allegation alone is enough to derail or end a promising career. Successful compliance requires an understanding of the law and your obligations under it. In light of recent developments regarding insider trading, including the first Supreme Court decision to address the crime in 20 years,[1] we encourage you to read this article in its entirety and contact us with any questions you may have.

Insider Trading: The Tradition

Section 10(b) of the Securities Exchange Act of 1934[2] and Rule 10b-5[3] promulgated thereunder prohibit insider trading. The basic elements of insider trading are: (i) engaging in a securities transaction, (ii) while in possession of material, non-public information, (iii) in violation of a duty to refrain from doing so.

The paradigm case discussing the so-called “classical” theory of insider trading is Chiarella v. U.S.[4] In Chiarella, an employee of a publishing firm was charged with insider trading after using advance notice of a takeover bid to trade. Chiarella’s conviction was reversed by the Supreme Court after the Court focused on the requirement of a duty running from the trader to the shareholders of the corporate entity “owning” the material, non-public information. Thus, a successful prosecution under the classical theory usually involves a corporate insider trading in shares of his or her employer while in possession of material, non-public information (e.g., advance notice of a merger).

After Chiarella, an important development in the law has been the extension of liability to persons who receive tips from insiders, i.e., individuals whose duty to refrain from trading is derived or inherited from the corporate insider’s duty. Thus, not only may insiders be liable for insider trading under rule 10b-5, but those to whom they pass tips, either directly (tippees) or through others (remote tippees) may be liable if they trade on such tips. Because tippee and remote tippee liability is more difficult to grasp and more likely to affect our readers, this article will primarily, but not exclusively, focus on individuals in those circumstances.

In a pattern that has repeated itself over the years, courts broadened the scope of insider trading by developing a second, “complementary”[5] theory of insider trading – the “misappropriation” theory. This theory “targets person[s] who are not corporate insiders but to whom material non-public information has been entrusted in confidence and who breach a fiduciary duty to the source of the information to gain personal profit in the securities market.”[6] The seminal case in the articulation of the misappropriation theory is U.S. v. O’Hagan. In O’Hagan, a partner at a large law firm (but not ours) obtained and traded on information given to attorneys in the firm who were representing a client in a tender offer. The Supreme Court held that “A person who trades in securities for personal profit, using confidential information misappropriated in breach of a fiduciary duty to the source of the information, may be held liable for violating § 10(b) and Rule 10b-5.”[7] In practical terms, under the misappropriation theory, individuals who come into possession of material, non-public information while providing services to corporate clients, such as the attorney in O’Hagan[8] may be held liable.

Joining Chiarella and O’Hagan in making up the traditional core of insider trading law is Dirks v. SEC.[9] In Dirks, the Supreme Court attempted to set a limit on the scope of insider trading.[10] Dirks was a securities analyst who learned from a former insurance company insider that the company was committing fraud and was on the verge of financial ruin.[11] Dirks investigated and disclosed this information to several people, including a reporter and clients who traded on the information.[12] Dirks was held liable for insider trading, but appealed.[13] The overturning of Dirks’s liability centered on the fact that the corporate insider had disclosed the fraud to Dirks purely by a desire to expose the fraud, rather than to obtain any financial or other personal benefit. The Court held:

In determining whether a tippee is under an obligation to disclose or abstain, it is necessary to determine whether the insider’s “tip” constituted a breach of the insider’s fiduciary duty. Whether disclosure is a breach of duty depends in large part on the personal benefit the insider receives as a result of the disclosure. Absent an improper purpose, there is no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach.[14]

Furthermore, Dirks introduced the idea that a tippee has to be actually aware of the tipper’s breach or presented with sufficient facts so that the tippee will be deemed aware. In this way, Dirks created a “personal benefit” element related to the tipper. After Dirks, prosecutors were generally confident they could prove this benefit existed as long as there was a quid pro quo or a moderately close relationship between tipper and tippee.

Newman: A Disruption

Chiarella, O’Hagan, and Dirks guided the law of insider trading largely uninterrupted for nearly 20 years. Then came a decision from the Second Circuit, the so-called “Mother Court”[15] of securities law, but an underling of the Supreme Court, called U.S. v. Newman.[16]

Newman involved a hedge fund portfolio manager who was part of an information-sharing cohort of analysts and portfolio managers.[17] By the time Newman received the tip, he was “four levels removed from the insider tippers,” (i.e., a remote tippee).[18] The tippers were insiders at technology companies who had provided information to what the court termed “casual acquaintances,” who in turn passed those tips on. Citing Dirks repeatedly for support, the U.S. 2nd Circuit Court of Appeals emphasized that government must prove the tipper received “a personal benefit” and that the tippee knew of that benefit.[19]

In Newman, the Second Circuit concluded that “the mere fact of friendship” was insufficient to give rise to the required personal benefit to the tipper. Instead, the court required “proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.” Despite the fact that the 2nd Circuit cited its adherence to Dirks in overturning Newman’s conviction, it was clear to all that by raising the bar for the evidence required to meet the Dirks “personal benefit” requirement, the opinion suggested a serious new limitation on insider trading law. Moreover, the prosecutors were denied a rehearing en banc and a Supreme Court writ of certiorari. This meant Newman would remain law in the most significant federal circuit for securities law until further notice.

One attorney called Newman “a well-deserved generational setback for the Government.”[20] The predicted effect of Newman was that the government would be forced to prove that someone charged with insider trading knew that she was trading on non-public, material information and that “the tipper’s goal in disclosing information is to obtain money, property, or something of tangible value.”[21] This heightened burden led to the reversal of more than a dozen insider trading convictions,[22] and pending cases were dropped.[23]

Salman: The Expansive View of Insider Trading Strikes Back

Newman’s holding concerning what qualifies as a personal benefit to the tipper was reversed last week when the Supreme Court issued its opinion in Salman v. United States.[24] Before the Supreme Court issued its opinion, in Salman, only the most ardent securities law gurus followed the case. So, some background may be helpful. Salman was convicted after trading on material, non-public information received from a friend, who had received the information from Salman’s brother-in-law. Thus, Salman was prosecuted as a remote tippee. He argued that he could not “be held liable as a tippee because the tipper (his brother-in-law, who worked on M&A matters at an investment bank) did not personally receive money or property in exchange for the tips.”[25]

In a strong rebuke, the Supreme Court held, “To the extent that the Second Circuit in Newman held that the tipper must also receive something of a “pecuniary or similarly valuable nature” in exchange for a gift to a trading relative, that rule is inconsistent with Dirks.”[26] Justice Alito succinctly explained “a tippee’s liability for trading on inside information hinges on whether the tipper breached a fiduciary duty” and that duty is breached “when the tipper discloses the inside information for a personal benefit.”[27] Such a personal benefit can be inferred where the tip is made “to a trading relative or friend.”[28]

Why Salman Matters

By allowing a generous inference of a benefit to the tipper based on a personal relationship alone, the Supreme Court in Salman reestablished the old order of things – an expansive scope for insider trading prosecutions. We understand that investment advisers are more likely than others to come into contact with corporate insiders, as well as those with whom corporate insiders speak in confidence. You know these individuals as professionals, former schoolmates, and even friends and family members. In discussing your work, it is quite possible that non-public, material information may be intentionally or inadvertently tipped to you. Your livelihood and liberty may depend on how well you understand your legal obligations when that happens. Fortunately, when you have questions about the rules regarding insider trading, we’re here to assist.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem offices. Clay Wheeler is a partner in Kilpatrick’s Raleigh and Winston-Salem offices. John Sanders is an associate based in the firm’s Winston-Salem office.

[15] James D. Zirin, American Bar Association, The Mother Court: A.K.A., the Southern District Court of New York, http://www.americanbar.org/publications/tyl/topics/legal-history/the-mother-court-aka-southern-district-court-new-york.html

[21]Salman v. U.S., available at https://www.google.com/url?sa=t&rct=j&q=&esrc=s&source=web&cd=2&ved=0ahUKEwihloXYvu_QAhVBjpAKHflsCIIQFggjMAE&url=https%3A%2F%2Fwww.supremecourt.gov%2Fopinions%2F16pdf%2F15-628_m6ho.pdf&usg=AFQjCNGY28IXIk-a-h-Nuvi5EXSHC6XW6g&sig2=Ydo5oy44CzIMDuCxjMluzA&bvm=bv.141320020,d.eWE (The opinion presents and rejects this argument from Salman before stating that the rule from Newman is inconsistent with precedent)

On October 12, 2016, the Securities and Exchange Commission (the SEC), announced its enforcement results for the 2016 fiscal year.[1] For all but the most dedicated followers of the SEC’s recent uptick in enforcement activities, the results are eye opening.

The Numbers

In 2016, the SEC filed a record 868 enforcement actions against a wide-range of actors.[2] This represents a jump of over 7.5% from 2015 and 15% from 2014.[3]The Wall Street Journal linked the record-breaking year to SEC Chair Mary Jo White’s “broken windows” strategy of pursuing “the smallest legal violations” as well as the serious, headline-grabbing frauds.[4] The effect, Chair White says, “makes you feel like we are everywhere.”[5]

Not only was the SEC able to increase the number of enforcement actions filed in 2016, it also was successful in obtaining over $4 Billion in disgorgements and penalties through favorable orders, settlements, and judgements.[6]

Insider Trading

Several of the highlighted enforcement actions for the year involve a point of perpetual emphasis for the SEC: insider trading.[7] In 2016, nearly 10% of all enforcement actions brought were related to insider trading. Several of those stemmed from what the SEC described as “complex insider trading rings” uncovered through “innovative uses of data and analytics.”[8]

One illustration of a complex insider trading ring involves two hedge fund managers and a former government official.[9] The former government official allegedly used deception, concealing his role as a hedge fund consultant, to obtain confidential information about upcoming approvals of generic drug applications from former colleagues at the Food and Drug Administration.[10] The SEC alleged that one of the hedge fund managers made unlawful profits of nearly $32 million by insider trading on tips he received from the scheme.[11]

Investment Advisers

The SEC also revealed that investment advisers were a primary target of SEC enforcement actions in 2016.[12] In fact, nearly 20% of enforcement actions brought during the year, were brought against investment advisers and investment companies.[13] This was another SEC record.[14]

Those who have been following the SEC under Chair White are not surprised by the surge in enforcement actions against investment advisers.[15] Chair White has moved examiners from the broker-dealer unit to the investment adviser unit of the Office of Compliance Inspections and Examinations in recent years.[16] Chair White has directed the enlarged staff to examine issues that generate conflicts of interest, such as cybersecurity policies and financial incentives.[17]

In a special section of the press release, the SEC highlighted some of its enforcements actions against advisers.[18] Among the highlights are eight actions related to private equity fund advisers.[19] Some of the entities and individuals involved are giants in the private equity industry: Blackstone Group,[20] Fenway Partners,[21] and WL Ross & Co.[22] Each paid fines related to its failure to adequately disclose certain fee arrangements.

The SEC also brought an enforcement action against three AIG affiliates which earned fees for steering clients into share classes of mutual funds that charged 12b-1 fees when the clients were eligible for share classes that did not charge such fees. In a release announcing the settlement of those claims, the SEC warned that “investment advisers must be vigilant about conflicts of interest when selecting mutual fund share classes.”[23] This mix of actions against investment advisers is an example of how the SEC’s broken windows approach creates the appearance of comprehensive enforcement.

New Tools

In reviewing the results of this record-setting year, industry participants should note what the SEC credits for its success. Chair Mary Jo White states that the SEC is “using new data analytics to uncover fraud, enhancing [the SEC’s] ability to litigate tough cases, and expanding the playbook bringing novel and significant actions to better protect investors and our markets.”[24]

Analytical technology is something that the SEC has been developing for several years.[25] The Market Information Data Analytics System (MIDAS), introduced in 2013, gives the SEC greater ability to reconstruct market data time-stamped to the micro-second.[26] Efforts to build the Consolidated Order Trail are still ongoing.[27] However, once that is on-line, the SEC should become even better at selecting and winning enforcement actions.

Conclusion

It is understandable if securities professionals reading these results do, in fact, feel that the SEC is everywhere these days. These results should trigger a recommitment to regulatory compliance that includes doing the little things right. We’re here to help.

Paul Foley is a partner with Kilpatrick Townsend & Stockton’s New York and Winston-Salem offices. John Sanders is an associate in the firm’s Winston-Salem office.